I received this question from Courtney:
“Can you talk about permanent life insurance, particularly whole life? I’d like to know when it makes sense to buy it instead of a term policy, especially when you’re young and healthy.”
Permanent life insurance comes in many shapes and sizes. In this 2-part series we’ll cover the basics so you know how it stacks up against a term life insurance policy. Plus, I’ll give you tips to buy permanent life insurance, if it’s the right choice for you..
In Courtney’s question, she mentions the two main types of life insurance: permanent and temporary, which is also known as term insurance.
Term life insurance covers you for a specified period of time only, like 10 or 20 years. You pay a fixed annual premium and receive a guaranteed death benefit.
Let’s say you have a $500,000 term policy that covers you through the end of 2030 and your spouse is the beneficiary. If you die before the end of 2030, your spouse would be entitled to a death benefit of $500,000. But if you die after 2030, your beneficiary wouldn’t receive a dime because your policy would be expired.
If you buy term life when you’re relatively young and healthy, it’s very inexpensive. For instance, if you’re in your 40s, a $500,000 policy might cost a few hundred dollars per year. You can typically renew a term policy for an additional term before it expires; however, as you get older the price increases significantly.
Permanent life insurance, on the other hand, covers you for your entire life, no matter if you live to be 100 years old.
In addition to providing a death benefit for your beneficiary, it’s also a financial investment. A portion of each premium you pay goes into an account that builds “cash value” on a tax-deferred basis. This is what makes permanent policies much more complex and expensive than term.
Types of Permanent Life Insurance
The 3 most common types of permanent life insurance are whole, universal, and variable. We’ll cover whole life in this episode and save universal and variable for part 2 of this series.
With whole life insurance, you pay a fixed annual premium, get a guaranteed death benefit, and a guaranteed rate of return on your cash value. This is the most straightforward type of permanent life policy—but it’s also the most expensive.
The reason whole life costs more than other types of term or permanent life products is because the premiums can never be increased throughout your life. Statistically, your chances of dying are very low when you’re young and healthy, and increase as you get older. So the product must be priced as if you’re going to live to a ripe old age.
That means in the early years of a whole life policy, the premiums are much higher than you’d pay for other types of life insurance. After the insurance agent receives a commission, a portion of your premium goes into conservative, fixed-income investments. That’s how the insurer generates a guaranteed return for you.
After a set period of time, you have some flexibility with the cash value in a whole life policy. For instance, you may be able to borrow against it or even cancel the policy and cash out an amount known as the surrender value. However, the longer you own a whole life policy the greater your total return will be.
Should You Buy Whole Life Insurance?
Let’s say you’re like Courtney, and are wondering what kind of life insurance to buy. Since the annual premium for a whole life insurance policy can cost as much as 10 times that of a term policy, you need to have a very good reason for buying it.
First of all, be certain that you need life insurance. If you don’t have dependents, a spouse, or partner who would suffer financially if you died, then you may not need life insurance.
The purpose of life insurance is to make sure people who depend on you could maintain their lifestyle or reach certain goals, like going to college, if you weren’t around. For many people, buying an inexpensive, 20-year term policy is plenty of protection.
However, if you’re certain that you want one or more beneficiaries to receive a payout no matter when you die, then you need a permanent life policy. This might be critical if you have a disabled family member, for instance, who can’t earn income or requires expensive, ongoing care.
In addition to providing long-term financial security for dependents, permanent life insurance can also be part of a savvy estate planning strategy. Your heirs can use the death benefit to pay estate taxes so they’re never forced to sell off your assets to satisfy Uncle Sam. However, for 2013, you get to exclude up to $5.25 million dollars of estate tax. So this would only be a good strategy when your net worth is substantially higher than the annual exclusion. But keep in mind that the estate tax exclusion is likely to drop in the future.
To sum up, whole life insurance generally isn’t recommended for young people because it’s so expensive. You have to pay upfront fees and commissions that usually reduce your annual return on the investment part of the policy, when compared to typical market returns.
Most people are better off making low-fee investments inside a retirement account, such as a 401(k) or IRA, that can provide more growth—and buying an inexpensive term life insurance policy to protect their loved ones.
Join me for part 2 of this series, where I’ll cover what you need to know about universal and variable life insurance. They offer more flexibility and potential benefits than whole life. Once you understand the range of permanent life insurance products that are available, you’ll know if it’s the best choice for your situation.